By way of background, the Wall Street Journal reported that the Department of Justice was seeking a settlement of $14 billion with Deutsche Bank for mortgage-related abuses. The Journal also noted that the bank’s thinking was that it should pay only $2 or $3 billion. The day after the story broke, the German bank took the unusual step of saying no way would it pay anything close to $14 billion. That seemed like an unwise move, particularly since in the JP Morgan and Bank of America settlements, there were also leaks about the amount the government was seeking, and the final deals came in not all that much lower than the figures bruited about in the press.

Deutsche Bank also tried arguing that it was being treated unfairly, and pointed to smaller settlements by other banks. However, TheStreet (hat tip Jon M) looked at Deutsche’s CDO activity relative to that of other banks that settled, and found that it is consistent with that of other settlements.

Mind you, the press stories so far have characterized the settlement as being about mortgage liability, which would make readers think of mis-selling of residential mortgage backed securities, and Deutsche was not a top player in that market. However, it was one of the big kahunas in the subprime CDO market. And as we explained at length in ECONNED, it was hybrid (part composed of actual bond tranches, part “synthetic,” meaning of CDS) that enabled BBB risk to be sold largely at AAA prices which not only kept the subprime party going well beyond its natural sell-by date, but actually drove demand to the very worst mortgages.

And not only was Deutsche a major actor, it was a particularly bad actor. Deutsche worked actively with the subprime shorts like Magnetar and John Paulson, who were creating CDOs for the express purpose of betting against subprime, meaning they wanted the CDO to reference the dreckiest mortgage securitizations they could find. As Greg Zuckerman explained in his book, The Greatest Trade Ever, Paulson was up front about his intent to create CDOs that would fail. Even Bear Stearns, not known for having lofty moral principles, turned him down, but Goldman and Deutsche had no such scruples.

TheStreet also says that Deutsche could get a break if the German government were to intervene. But as we pointed out in Links yesterday, via Michael Shedlock, the German press is reporting that Merkel will not intervene on behalf of the beleagured bank, either to give it a bailout or to press to have the DoJ back off. This is consistent with what I’ve heard from German contacts, although they don’t think official thinking is terribly realistic. The plan is to stay hands off, at least through the German elections in 2017. However, it is hard to see how the slow-moving Italian banking crisis can be kept under control that long. Deutsche is next in line if Italian banks start keeling over.

And anything within hailing distance of a $14 billion fine would hit Deutsche hard. It has only €5.5 billion in litigation reserves, which is equivalent to a bit over $6 billion. It’s stock price is already battered, and with a market cap of a mere $18 billion, coming up with a few billion more would be costly..

However, as we’ve also pointed out, historically there has been a huge gap between the headline amount of mortgage settlements and the cash amount paid. The settlements have been larded up with gimmies to consumers like promises to modify mortgages and make short sales, which inflict costs on MBS investors far more than the bank making the settlement. However, Deutsche isn’t a large mortgage servicer, so it may have less ability to trade in non-cash goodies to give the DoJ the big number it seeks while minimizing hard dollar payments.

Deutsche Bank insiders quoted by The Financial Times have said the bank hopes it will be treated like Goldman Sachs (GS) , which ended up paying only about $5 billion….

Any attempt to get Goldman-like treatment could be tricky. In the pre-crisis housing market, Deutsche Bank appears to have been printing far more collateralized debt obligations. Deutsche created about $42.5 billion worth of the debt packages vs. about $25 billion by Goldman in 2007 alone, according to a 2010 Wall Street Journal report, which cited data compiled by Thomson Reuters. (Meanwhile, according to the report, Bank of America and JPMorgan issued about $65.5 billion and $44.3 billion in CDOs, respectively, over the period.)…

One of the striking similarities between the two banks is that they appear to have both allowed hedge fund billionaire John Paulson to bet against the housing market while promoting the market to clients. However, the Journal noted “a key difference” in their report: “Goldman told investors that the assets were picked by an independent third party; Deutsche didn’t use a third party or give its investors any assurances.”

Both Goldman and Deutsche Bank were also market-makers for traders interested in shorting the housing market more broadly, as they acted in that capacity through the ABX credit-default index… Deutsche Bank banker Greg Lippman…helped establish the index.

We’ve called Greg Lippman “patient zero” of the toxic phase of the subprime market, which started in the third quarter of 2005. From ECONNED:

Mortgage industry graybeard Lew Ranieri, who effectively created the mortgage-backed securities industry at Salomon Brothers in the 1980s, dates the toxic phase of subprimes to roughly the third quarter of 2005 through early 2007, and points to a sudden shift in demand and attitude toward the riskiest assets. That coincides almost exactly with when ISDA made credit default swaps on asset-backed securities and exposures like CDO tranches possible, in June 2005, after allowing for the lag required for the new hunger to result in more mortgage creation.

Goldman and Deutsche were the driving forces behind the new ISDA protocol.

So Deutsche might not get away with this as cleanly as it would like, although it’s hard to imagine that the German government will sit on its hands if Deutsche were to go wobbly. Perhaps it’s hoping that the usual European “kick the can down the road” approach will allow the DoJ settlement talks to drag out past the German elections, allowing for more, um, creative solutions.

But Mr. Market isn’t happy about the current state of play. Per CNBC as of Monday morning in Germany Live: Deutsche Bank shares slump 6% as Merkel reportedly rules out state aid. Note that CNBC pooh-poohs the Focus story that made the claim that Merkel would be hands off because it did not name any government sources. But as indicated, I’ve been hearing the same thing for weeks, so despite the fact that it would seem to be impossible not to bail out Deutsche, the political sentiment seems to be that it would be fatal for the already wobbly Merkel to do so. After all, she was at the helm during the crisis. She can’t pin the blame for the failure to fix the bank on someone else.

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31 comments

Ultimately, Deutsche Bank is really a metonymy for a hierarchy of people following orders. As they say, “A fish rots from its head.” How long before we see Josef Ackermann, the top order-giver during this particular period, doing the perp walk?

I don’t agree with that at all. If you are at all familiar with the history of CDOs, Greg Lippman operated with considerable autonomy.

And in general, in investment banking operations, the folks at the top don’t choose to and can’t direct the actions of those lower down. As I wrote in ECONNED:

On paper, capital markets enterprises look like a great opportunity. The firms that are at the nexus of global money flows participate in a very high level of transactions. Enough of them are in complex products or not deeply liquid markets so as to allow firms to find ways to uncover and in many cases create and seize profit opportunities. New, typically sophisticated products often provide particularly juicy returns to the intermediary. And in theory, clever, adaptive, narrowly skilled staff can stay enough ahead of the game so that the amount captured off this huge transaction flow is handsome.

Once again, however, the real world deviates in important respects from the fantasy. Why? This business model is also a managerial nightmare. We have a paradox: “success” and profitability in the investment banking context entails giving broad discretion to individuals with highly specialized know-how. But the businesses have outgrown the ability to monitor and manage these specialists effectively. The high frequency, meaningful stakes, and large absolute number of decisions made at the operational level, the geographic span of these firms, and the often imperfectly understood interconnections among business risks make effective supervision well-nigh impossible.

The capital markets operations of a TBTF firm are nothing like retail banking, which is extraordinarily tightly controlled and monitored. Low-level employees have no discretion in a retail bank and extremely high discretion in an investment bank.

The truth is there are plenty of other industries in which upper-level managers must give broad leeway to highly specialized employees whose work they only partly understand. Just ask an MBA CEO of a hospital how a brain tumor is taken out… Indeed, the entire cartoon ‘Dilbert’ and its prototypical pointy-haired boss is precisely about this problem. While this does lead to suboptimal management, in no other industry has it caused the spectacular failures we’ve seen in finance (although maybe we’re getting close in medicine…).

Why is that? I’d argue it’s because the higher ups don’t want to know. Most financial “innovation” these days is about figuring out ways around regulatory prohibitions against fleecing your clients and/or staying one step ahead of the ones smart enough to figure out your schemes. Regardless of the long-term health of the company (nevermind their clients or the world at large), as long as those specialized employees continue generating outsized profits, what do you gain by poking around and seeing if they’re causing long-term problems or even breaking the law?

Ever since the big I-banks stopped being partnerships (where the partners had their own capital at stake) and became corporations, there is absolutely no reason for a CEO to question whether a trader who generates $1bil in profits is doing something shady. Indeed, when he must make the inevitable trip to Congress to be grilled in front of a committee, what’s better: claiming ignorance, or having a Senator hold up an email proving he knew exactly how the scam was being run all along?

One must make the distinction between conventional mortgages and subprime mortgages. Supposedly convention mortgages were sold to the GSEs which enticed investors ala the government guarantee. It is the GSE Business Model that drove the insatiable appetite for the MBSs. Along came “subprime” MBSs offering higher returns by people like Deutsche, however investors demanded the same guarantees as the GSEs offered and from a competitive sense they complied (mortgage people thought their stuff didn’t stink).

One problem……the GSE Business Model was “fatally flawed” for a million reason if you have a problem getting by the first reason eg the government guarantee. So the non GSE loans actually mimicked a GSE Model that simply did not work, thus the implosion.

Of course while all this was unfolding the GSEs felt the pressure and incrementally lowered standards which were almost non existent to begin with. The rest is history. The bad news is the fact that there is an effort afoot to breath life back into the GSEs using the threat of the loss of the 30 yr mortgage (red herring).

We have learned enough about the GSE Business Model to know that we should never consider it again. .

I’ve thought along similar lines, but I always then end up with a set of follow-on questions which are implied if we do a thought experiment which concludes with the (probably for the best) doing-away with the GSEs.

Which is: if the GSE model is pants, what is the optimal solution?

I am not at all keen to suggest just throwing housing finance into the (not so) tender ministrations of the private sector.

So, okay, then we should have nationalised provision of long term retail housing finance. But how do we prevent the inevitable propensities for people (borrowers or the government as lender) to abuse the provision? Normally, I’d proffer some sort of “regulatory regime” to ensure strict underwriting criteria, fraud prevention and deterrent to gerrymandering.

But I’m not entirely happy with that, either. It all smacks a bit too much of a Magic Regulator Fairy, infinitely trustworthy, unimpeachable in its judgements and staffed entirely by Archangels. Not. Gunna. Happen. Ev-ah.

You or I or a thousand other people concerned could not write the GSE (FNNA) Guidelines any better—–they read like the Ten Commandments. All player partners in the Model must sign guaranteeing buyback FOR ANY REASON OR NO REASON AT ALL. Very good, very clear and how we would want things if we were in heaven. Congress wittingly or unwittingly bet the farm (taxpayer’s wallet) in issuing the guarantee to the GSE MBSs, first implied and now explicit.

Recently we all witnessed how Congress members treated Mr. Stumpf of Wells Fargo with disdain and ridicule which gives the impression that they are “doing something”. Where were the congress people in leading up to the hearing (years after the dirty deeds)? Where was regulatory folks always acting afer the disaster?

If you can forget for a moment that we the people elect the congress people, one has to wonder where they were in designing the oversight of the bet made on the GSE Business Model. A simple audit of compliance with GSE Guides proffering representations and warranties could have revealed mischief early on. No one was auditing. They are still not auditing perpetuating the fraud.,

Congresses’s answer to date for their failure in oversight are programs like HAMP, etc. “You were screwed, now we are going to screw you again”. An ever evolving GSE Business Model to perpetuate the sham itself.

For sure, we do not need the government in industry. The “guarantee” issue kills any competitive activity in the private sector. There is no such thing as a “guarantee”. Accordingly when congress heard it on the first day, they should have run the other way. To think otherwise you would have to subscribe to the notion that government can run business better than private enterprise.

I have faith in the free enterprise system, not a pseudo free enterprise system.

One option might be to prevent the selling or bundling of mortgages from the originator bank? In other words, a bank that makes a home loan is stuck with that loan until the owner pays it off, the owner dies, or the owner defaults, etc.

Underwriting standards. Without the creation of the NINA (No Income No Assets) and SISA (Stated Income and Stated Assets) underwriting classes there would have been no crisis.

SISA loans were historically sold to self-employed people who had to produce mounds of Tax Returns to substantiate their “Stated Income”

The system was gamed from the very top by the creation of these underwriting classes. The loan committees of all the lenders had to agree and document their acceptance of these categories. Loan committees are composed of the most senior management in any Bank.

I have not read of any evidence of a ficus by the US DOJ on underwriting standards and the memo trail of approvals from these committees. But now I expect they have all been shredded.

Aka: Massive, institutional cover up at he highest levels in Banking and Government.

Well… I thought so too. But then I hit on my problem about how, okay, you can have robust, detailed and appropriately specified underwriting (for the loan eligibility as well as for things like contraction standards, so the government doesn’t get stiffed having to buy back properties with defective septic tanks, etc. etc.) but then you need able and adept control and monitoring plus no-holds-barred pursuit of any miscreants who falsify or fraudulently represent the loan book they are asking the GSE-type entity to backstop.

But this is where we came in, isn’t it? Captured regulators, revolving doors, pay-to-play scams, — all manner of shenanigans to provide a “short term” “loosening” of “overly tight criteria” to help borrowers, house builders, local markets, local banks, my mother-in-law’s-cat, whoever — and so on. It’s (given the incentives and the sums involved) catnip for the unscrupulous on all three sides of the borrower-lender-underwriter triangle.

Not to mention what IMHO was the most powerful agent of corruption, certainly in the latter stages, the crooked appraisal industry (comes out clearly in the Big Short movie). That was the final bit of “cover” needed for sub-prime inflation to head for starts.

They did NOT blow up because they made guaranteed mortgages. Their losses in the crisis were higher than their models predicted but not all that much.

They went under because they invested the money they got from their guarantees heavily in subprime loans. It was partly stupid greed (as in taking more risk would increase GSE profits and hence pay of the execs) and partly politically expedient (it earned them points in Congress).

In addition, CDOs are not residential mortgage bonds. Deustsche would BUY, not sell, the BBB- tranches of RMS (the ones nobody wanted) and package them into CDOs. If CDOs had not come along, the inability to sell the BBB- tranches of RMBS would have stopped the growth of that market at a much lower level. Another way to look at the “nobody wants this tranche” problem is that too many people had to take fees and costs out of a subprime mortgage securitization to make the entire deal attractive for investors. But rather than have someone get less rich and pay investors more for the risk, CDOs effectively created a Ponzi to keep rolling this part of the mortgage deal (about 3% of par value) forward.

Unfortunately I know more about the mortgage industry than I ever wanted to know.

You miss the elephant in the room as to the causal nexus and why the “guarantee” is the genesis of the meltdown. All of the subsequent calamity followed that fatally flawed concept.

It is all about the question proffered by Wall Street financial people asking “how do we sell this crap (MBSS)? The only way they could sell it is to assure investors that “what are you worried about—-our crap is guaranteed by the US Government”.. Without that guarantee they would be out there in the market place selling the same crap as everyone else.

With the guarantee, investors are saying “what do we have to loose—-they are guaranteed”. If they did not have the guarantee what advantage does their MBSs have over non guaranteed MBSs? So goes the story—-everyones eyes are glazed over, due diligence unnecessary, etc.etc.

Investors are not innocent either—-the GSE Business Model (guaranteed) made no business sense at all to any creditable investor but they said “how could this be wrong—we are getting a check every month?”. They were ignoring common sense. When was the last time you heard the auto salesman say “if you don’t like it bring it back, they are guaranteed and we will give you your money back”. That is exactly what they say about mortgages.

If you want to clear the room ask the financial hucksters to proffer a MBSs model that doesn’t need the government guarantee. None will be found unless and until the guarantee is killed putting all on on a even field. Only then you will conclude “do I really think that we can’t have a mortgage business without the government?”

Any merchant on 5th Avenue can tell you in a moment what this is all about as they have seen it for years in Americas retail mercantile industry from which I am from.? 7th Avenue factoring companies can tell you all about sifting through faulty accounts receivable generated bu non existent guarantees made by errant sales practices.

Take away the guarantee and peddlers are stripped of their competitive advantage and would have to rely on best practices over all others (God forbid). What fun is that when the guarantee puts you in the front seat with investors? You don’t need to be a salesman if you ware are guaranteed by the US Treasury.

The guarantee is the mortgage industry’s heroin—–feels great—but rotting our brains.The crap will end up killing us all (ditto edu the same GSE Business Model ).

Goldman’s earlier CDOs in its Abacus program in 2004 and 2005 (which was larger than Deutsche’s Start program of synthetic CDOs) were entirely to hedge its own book and so the authorities were unlikely to have a problem with that. We did have a huge spreadsheet that I could dredge up again as to who did which Magnetar CDOs, which were the most destructive. My dim recollection is that Goldman was not much involved with Magnetar.

According to a July 30, 2014 letter from Deutsche Bank National Trust Company to certain certificate holders (in its position as Trustee) is an attached exhibit which basically explained that it had 21 trusts that were so toxic that The Ratings Agencies wouldn’t even let Ocwen take them on, so SLS (Specialized Loan Servicing LLC) was to be assigned the trusts for servicing.

Below, two of the 21 trusts are listed, each identified by the name of each trust and the CUSIPS included in the trusts, as well as the class numbers of each CUSIP. But the two listed below are 100% identical.

My question is the following: How does something like this happen? Is it an example of a mirror trust or double pledging or re-pledging (rehypothecation?) or what?

I checked with the SEC.gov website and the two trusts were registered within months of each other. The 2004-AR4 was originally to be underwritten by Bear Stearns and Goldman Sachs, but ended up being underwritten by Lehman Brothers. The 2004-AR10 was underwritten by RBS.

The Central Index Key (CIK) for the 2004-AR10 is 0001304839. The CIK for the 2004-AR4 is 0001296269 on the sec.gov website.

I would greatly appreciate any explanation as to how this could have happened and what it might suggest…..

Thank you Griffen. I spoke with a VP of Structured Securities way back then (I can’t remember if she worked for Fitch or Moody’s) but I got the idea that the trusts that were not given a “thumbs up” to go from OneWest to Ocwen had to, instead, go from OneWest to SLS, which basically comports with the Deutsche letter.

But I just want to know how it is possible that one trust could, from the standpoint of its CUSIPS, be absolutely identical to a totally different trust.

I’m a housewife. I don’t get out a lot. And when I do, those with whom I interact tend not to have much expertise in, ya know–remarkably complicated financial securities!

So I really appreciate that you took the time to read and reply to my comment! ;-) Thank you so much.

You are immersed in a shell game called the GSE Business Model where there exists a feature that defies logic. The nexus between borrower and lender has been severed. This defies common sense and is probably second in line to the guarantee as to the genesis of the sham (Model does not work).

Further transactional issues abound in MBSs. Your goal needs to be determined.l

So, as with previous posts and threads in this forum, where does all this settlement money supposedly go? To the future loan loss reserves less expenses? To some general fund? Sorry for the infantile question.